How Risk Management Is Strangling Our Economy

Scenario 1. After six years of work, Mike finally
established his own retail business on Gotham Street in the Big City.
His first week was a heady mix of first sales, getting to know
neighbors, and realizing he’d accomplished his dream.

On Monday of Week 2, Mr. X came to visit. “Nice store you’ve got
here,” he said to Mike. “Be a shame if something happened to it.”

“Why would anything happen to it?” enquired Mike, part disbelieving and part enraged.

“You just never know,” said Mr. X, slapping his walking stick
repeatedly into his palm. “Things can happen. You got no control over
‘em. But we can help.”

“How?” asked Mike, dreading the answer.

“Think of it as insurance. A little extra off the top line, nothing
happens to the bottom line. Safest neighborhood around, if you know how
to get along.”

“Not fair--that’s a good one! Listen, if I cut you a break,
everyone wants one. If it was up to me, I’d do it, I like you. But Mr.
Big—he wouldn’t like that.”

“Maybe I could talk to Mr. Big,” said Mike.

“Oh I don’t think that’d be a good idea,” Mr. X said drily. “All
right, I think we’re done here, Mikey. I’ll come by on Monday for your
first payment.”

Scenario 2. After six years of work, Mitchell
finally formed his own subcontracting business, taking the plunge with
a big deal from his former employer, BigCo.

As he read through the fine print of the contract, Mitchell noticed
several clauses that surprised him. He called BigCo’s in-house counsel,
Mr. Z.

“Mr. Z, this is Mitchell. I’m going through this contract, and it
says I have to buy millions of dollars of insurance coverage, with
BigCo as beneficiary, to cover things like lawsuits filed by anyone
anywhere in the world for things like bodily injury, automobile
crashes, etc. Look, I’m just an actuary—I’m hardly ever going to set
foot there, much less cause all kinds of harm. These things will never
happen.”

“Well, the most unlikely things have a funny way of happening,
Mitch,” said Mr. Z. "It’s a big world, you can’t be too careful.
We're just managing risk. Think of it as insurance. Which of course
it is. It's really for your benefit, you wouldn't want to be liable
for these catastrophes, now would you?”

“But why me,” asked Mitchell. “I can’t afford this kind of extra
insurance. And you want me to buy insurance on people I sub to as well?
Does this ever end?”

“Oh don’t worry about that, Mitch—you just pass it on to your subs
in your agreement. That’s what we did, when our customer demanded we do
it. It’s how it works.”

“Is that where it starts, with your customer? Couldn’t we talk to them?”

“Oh I don’t think that’s going to happen, Mitch. Just work out the cost and pay it.”

“But it’s not fair, Mr. Z.”

“Mitchell, Mitchell, you know better than that,” said Mr. Z.

So here’s my question about the two scenarios:

What’s the difference between them?

My lawyer friends (I hope I still have a few) will say, “That’s
insulting! Come on, one of them’s legal, and one’s criminal—how can you
confuse them?”

But my economist friends (some of them anyway) will say, “Ha! It’s
a trick question. There is no difference, they’re exactly the same.”

“Both of them involve non-value-adding transaction costs. There is
some amount of risk transfer between parties—swapping around,
really--but to the system, there is no gain.

“In fact, at the system level, there is a net cost; and the
distribution of that cost is disproportionately downstream, to Mike and
to Mitch.

To put this in context: our economy used to grow by
achieving scale through transaction costs—legal agreements, accounting,
contracts, commission plans.

Today, we are so inter-linked and fragmented, and so paranoid about
trusting, that the transaction costs have begun to overtake the value
accruing from scale.

We have become a culture not of shopkeepers, but of tiny outsourcing
transactors, fearfully insuring ourselves against our
fellows-in-commerce at every step.

As my friend Bill says, "What is a credit default swap except a statement that you don't trust your customer?"